The battle between mutual funds and exchange-traded funds is over. ETFs won.

It wasn’t easy. ETFs have been around for nearly three decades, and hardly anyone noticed for a long time. The first ETF, State Street’s SPDR S&P 500 ETF Trust, debuted in 1993. By the mid-2000s, there were roughly 350 ETFs, but the industry had gathered just $320 billion from investors from 1996 to 2006, according to Morningstar’s earliest available numbers. Meanwhile, mutual funds scooped up close to $2.3 trillion during the same time, their ranks swelling to 6,500 funds at the end of 2006.

Indeed, the mutual fund industry was a formidable adversary when ETFs came along. It reliably generated tens of billions of dollars a year in fees, mostly from high-priced actively managed funds, so it was plenty motivated to keep the cash flowing. It paraded its star managers to distract investors from mounting evidence that most managers fail to beat their benchmarks. It paid kickbacks to a sprawling network of brokers and advisers who stuffed client portfolios with expensive funds. It was also fortunate that the dot-com crash in 2000 hit internet companies and growth stocks hardest, sparing active managers who had avoided them and shielding their investors from much of the wreckage.

The next crash wasn’t as forgiving, and it gave ETFs their big break. The financial crisis ripped through markets beginning in late 2007. Managers had few places to hide, and actively managed mutual funds took a beating. Disappointed investors started shopping around. “There was a huge rush into passive investing,” Dave Nadig, director of research for ETF Trends, told me. “Investors flushed their overpriced benchmark-hugging active funds and reallocated to cheap and boring ones, having had their hands burned. They also took tax hits from decades’ old positions, either saying ‘enough is enough’ or booking actual tax losses.”

ETFs, with their stable of low-cost index funds that tracked broad markets, were perfectly positioned to give investors what they wanted. They took in an additional $300 billion in 2007 and 2008, and the money kept pouring in from there. Investors have handed $4 trillion to ETFs since 2007 through August, compared with $1.6 trillion for mutual funds. And there are now more than 2,500 ETFs, while the number of mutual funds is down modestly to around 6,300 since 2006. Looking back, it’s a wonder it took investors so long to discover ETFs. While they’re almost identical to mutual funds, ETFs differ in two ways that give them a demonstrable edge. One is cost. The median expense ratio for U.S.-based ETFs is 0.5% a year, compared with 0.93% across all share classes of mutual funds. The savings can add up to tens of thousands of dollars or more over an investing lifetime.

ETFs are also more tax efficient. When investors pull money from a mutual fund, the fund must sell some of its holdings to generate the necessary cash. If those holdings have appreciated in value, the fund’s remaining shareholders are stuck with the tax bill. ETFs, by contrast, trade like stocks — investors buy and sell ETFs from one another, so the fund isn’t involved and its investments undisturbed. (I’m referring to open-end mutual funds, which is what most investors own. Closed-end mutual funds trade like ETFs.)

Trading like stocks has other advantages. ETFs trade all day, so investors see the price when they buy and sell. Mutual funds, on the other hand, are priced at the end of the day at the fund’s net asset value (NAV), or the value of its holdings at market close. Investors must therefore place trades without knowing the price, which can result in unwanted surprises on volatile days. Most mutual funds also impose minimum investments, whereas anyone can buy an ETF. Some brokers even allow investors to purchase fractional ETF shares, so they can get started with just a few dollars.

ETFs have some downsides, but they’re easy to navigate. For one, ETFs typically don’t trade at NAV, so it’s possible to pay more than the fund’s underlying holdings are worth. Investors can manage that risk by choosing ETFs that closely hug their NAV, and most do. Roughly two-thirds of ETFs traded at an average premium to NAV of 0.1% or less during the past 12 months, and about a third of those traded at a discount. Also, like all traders, ETF investors must make sure their trades are executed at or near the quoted price. The risk of an errant trade is exceedingly low for ETFs with a lot of trading volume. […]

source The Era of Mutual Funds Is Dying. Long Live ETFs.

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